Mutual Fund Education
Dividend Reinvesting Explained for Mutual Fund Investors
Chris Dumont Dec 02, 2014
What Is a DRIP and How Can You Get One?
Be sure to also take a Look Under the Hood of the 10 Biggest Mutual Funds.
Creating a DRIP account does take some time, and the hassles and expenses of setting one up can turn some investors off. Investors should first research to see what companies or mutual funds offer DRIPs and which do not. After that, determine who runs the plan, whether it’s the company or a third party. Finally, you will have to purchase at least one share of the company in order to qualify for a DRIP. If a company does not offer a DRIP, look at your brokerage and see if it offers that service.
The Benefits of Reinvesting Dividends
It can be next to impossible to predict the bottom and so DRIPs can take out the emotion by automatically investing for you.
Another benefit is that some companies are so eager to sign up investors to their DRIPs that they offer small discounts on their stocks. The incentive for the companies is that they save on their financing costs; instead of sending cash to shareholders they can just simply issue more shares. Company-run DRIPs allow investors to purchase fractional shares, and like mutual funds, DRIPs can be used with little capital. Lastly, with non-broker DRIPs, there is often zero reinvestment costs involved.
The Drawbacks of Reinvesting Dividends
Dividend reinvesting happens automatically with a DRIP, which can happen when the stock is at a less attractive price; there is no control over the price paid for the stock. Lastly, DRIPs are not diversified and you face the opportunity cost of giving up investing the dividends on your own in another stock.
One misconception about DRIPs is that they are not subject to tax because the investor is not receiving cash. Cash is still technically received, but it was reinvested and as such the dividend is considered to be income and is still taxable. As time passes and the stock potentially increases in value and is eventually sold, there will be capital gains tax paid on the investment as well.
When buying and selling shares directly through a company, there is less liquidity compared to buying and selling stocks on your own. With a DRIP, selling can be quite restrictive; you may be required to wait until the end of the trading day or be required to sell all of your shares when you only wanted to sell a few.
Reasons to Pass on Dividend Investing
The Bottom Line
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